An extremist, not a fanatic

April 15, 2014

What Phillips curve?

Today's news that CPI inflation has fallen to its lowest rate since October 2009 poses the question: what is the relationship between unemployment and inflation?

The fact that the fall comes after months of falling joblessness is awkward for conventional Phillips curve-type thinking, which says that lower unemployment should lead to higher inflation.

In truth, the latest episode is not unusual in this regard. My chart plots unemployment against CPI inflation in the following 12 months since the Bank of England was given independence in May 1997. It's clear that there's no neat single Phillips curve. In fact, taking all the data together gives us a positive correlation between unemployment and subsequent inflation; it is higher unemployment that leads to higher inflation, not lower.

I suppose you could espy a Nairu at around 5.3% and another at around 7.8%. But this doesn't help us with the current inflation outlook, as it merely poses the question: does falling unemployment mean there's the risk of inflation picking up, or does it mean the Nairu is falling?

There are several possible reasons for this apparently perverse relationship, most of them mutually consistent. Maybe this shows that inflation expectations matter; at a given unemployment rate, higher expected inflation will lead to higher actual inflation. Maybe it shows that shifts in the Nairu are of big practical significance. Maybe (relatedly) it tells us that supply shocks matter a lot; it could be that inflation and unemployment have both fallen because of a mix of lower commodity prices and a pick-up in productivity. Or maybe it means that the idea of an inflation-unemployment trade-off is dubious in an open economy:

In the closed economy there is a unique unemployment rate consistent with constant inflation. By contrast, in an open economy, there is a range of unemployment rates consistent with the absence of inflationary pressure. (Carlin and Soskice, p343)

Whatever the reason, the conclusion is the same. Statements such as "there is every chance inflation will pick up as economic slack is eroded" are more questionable than Phillips curve intuition suggests. Yes, inflation might rise. But you need to do much more than point to falling unemployment to believe it will.

This poses the question: why, then, are such statements so common?

One possibility is that we are unduly influenced by closed economy thinking in which there should be an unemployment-inflation trade-off. Because there's such a trade-off in the US - and because it's plausible that mass unemployment is causing low inflation in the euro area - we tend to think the same must be true in the UK. But it ain't necessarily so.

A more benign possibility is that such thinking is a way of smuggling demand management into monetary policy. The belief (or statement!) that a big output gap would reduce inflation allowed the Bank to slash rates in 2008-09. In truth, the claim "bugger inflation: let's try and save the economy" would have done just as well, but waffle about spare capacity allowed the Bank to appear to reconcile demand management with inflation targeting.

There is, though, a nastier possibility which Michal Kalecki famously pointed out - that the possibility of fuller employment makes many capitalists rather jumpy. But then, Kalecki can't possibly have been right, can he?

Comments

Another possibility is thus. The Bank of England reckoned that a significant amount of inflation over the last four years or so was cost push. If that effect is fading, then you’d tend to get falling inflation combined with a constant or even falling level of unemployment.

The other possibility is that the actual inflation data is totally bogus. Take into consideration the massive increase in the price of housing faced by workers, particularly in London, whether to buy or to rent; take into consideration that as the bubble of share prices and bond prices gets blown up, workers pension contributions buy fewer and fewer bonds and shares, and the yield on those bonds and shares declines, making it more and more difficult to provide the income required to pay their pensions or annuities, so the real cost of buying pension provision has been massively increased by the blowing up of asset price bubbles via money printing and the real rate of inflation faced by workers is many times the official figure.

I could easily construct an inflation index that gives the figure required if you let me include or exclude the relevant data in the way the ONS data does!

Oh I should have also included that another effect of the cuts is that where services were previously provided free or heavily subsidised by Local authorities, and then aren't this is an additional expense for workers then having to pay for them, but doesn't show up as a price rise. In the same way, if part of your cost of rearing children was covered by a Child Tax Credit, which is then reduced or withdrawn that is a real increase in your child care costs.

If the unemployment, even if decreasing, is above the NAIRU, I think that it is expectable that the inflation be also decreasing - the inflation should only begin to rise only when the reduction of the unemployment put it below the NAIRU.